Chapter 10 (The Monetary System)

Question 1

Whether you pay by cash, cheque, or debit card, the restaurateur is happy to work hard to satisfy your gastronomical desires in exchange for these pieces of paper and plastic that, in and of themselves

Answer 1

are worthless

Question 2

Without money, people would have to rely on

Answer 2

barter-the exchange of one good or service for another-to obtain the things they need.

Question 3

An economy that relies on barter will have trouble allocating its scarce resources efficiently. In such an economy, trade is said to require the

Answer 3

double coincidence of wants-the unlikely occurrence that two people each have a good or service that the other wants

Question 4

As money flows from person to person in the economy, it facilitates production and trade, thereby allowing

Answer 4

each person to specialize in what he or she does best and raising everyone’s standard of living

Question 5

Economists, however, use the word in a more specific sense: Money is

Answer 5

the set of assets in the economy that people regularly use to buy goods and services from other people

Question 6

According to the economist’s definition, money includes only those few types of wealth that are

Answer 6

regularly accepted by sellers in exchange for goods and services.

Question 7

Money has three functions in the economy:

Answer 7

It is a medium of exchange, a unit of account, and a store of value. These three functions together distinguish money from other assets in the economy, such as stocks, bonds, real estate, art, and even
hockey cards.

Question 8

A medium of exchange

Answer 8

is an item that buyers give to sellers when they purchase goods and services.

Question 9

A unit of account

Answer 9

is just the money as a unit of measure to have a balanced exchange

Question 10

A store of value is

Answer 10

an item that people can use to transfer purchasing power from the present to the future

Question 11

The term wealth is used to refer to the total of all stores of value, including both

Answer 11

money and nonmonetary assets

Question 12

Economists use the term liquidity to describe

Answer 12

the ease with which an asset can be converted into the economy’s medium of exchange. Because money is the economy’s medium of exchange, it is the most liquid asset available

Question 13

When money takes the form of a commodity with intrinsic value, it is called

Answer 13

commodity money. The term intrinsic value means that the item would have value even if it were not used as money. One example of commodity money is gold.

Question 14

When an economy uses gold as money (or uses paper money that is convertible into gold on demand), it is said to be operating under

Answer 14

a gold standard.

Question 15

Money without intrinsic value is called

Answer 15

fiat money. A fiat is simply an order or decree, and fiat money is established as money by government decree

Question 16

the quantity of money circulating in the economy, called the

Answer 16

money stock, has a powerful influence on many economic variables

Question 17

The most obvious asset to include is currency

Answer 17

the paper bills and coins in the hands of the public. Currency is clearly the most widely accepted medium of exchange in our economy.

Question 18

Gold not other substances because

Answer 18

we want something that won’t be quickly destroyed, something that won’t destroy us and something that isn’t volatile

Question 19

To measure the money stock, therefore, you might want to include demand deposits

Answer 19

balances in bank accounts that depositors can access on demand simply by writing a cheque or using a debit card

Question 20

Although at first this argument may seem persuasive, credit cards are excluded from all measures of the quantity of money

Answer 20

The reason is that credit cards are not really a method of payment but a method of deferring payment.
When the time comes to pay your credit card bill, you
will probably do so by writing a cheque against your chequing account. The balance in this chequing account is part of the economy’s stock of money

Question 21

Even though credit cards are not considered a form of money

Answer 21

they are nonetheless important for analyzing the monetary system.

Question 22

Thus, the introduction and increased popularity of credit cards may

Answer 22

reduce the amount of money that people choose to hold.

Question 23

Whenever an economy relies on a system of fiat money, as the Canadian economy does, some organization must be responsible for controlling the stock of money

Answer 23

In Canada, that organization is the Bank of Canada.

Question 24

The Bank of Canada is an example of a central bank

Answer 24

an institution designed to control the quantity of

money in the economy

Question 25

Other major central banks around the world include the

Answer 25

Bank of England, the Bank of Japan, the European Central Bank, and the Federal Reserve of the United States.

Question 26

Until the Great Depression of the 1930s, Canada had no central bank.

Answer 26

Bank notes were issued by the Department of Finance and by the large commercial banks

Question 27

The monetary system was regulated by the Department of Finance, acting in concert with those large commercial banks. The gold standard
ensured that bank notes could normally be exchanged for a fixed quantity of gold. The economic problems of the Great Depression, and the need to control the
quantity of fiat money when the gold standard collapsed, led the government to set up a royal commission to study the issues.

Answer 27

The commission recommended that a central bank be established. As a result, in 1934 Parliament enacted the Bank of Canada Act, which laid down the responsibilities of the Bank of Canada. The Bank was established in 1935 and nationalized in 1938, so it is now owned by the
Canadian government.

Question 28

Commercial banks

Answer 28

are owned by their individual shareholders

Question 29

The Bank of Canada has four related jobs. The first is to issue currency.

Answer 29

The second job is to act as banker to the commercial banks. The third job is to act as banker to the Canadian government.

Question 30

The Bank of Canada’s fourth and most important job is to control the quantity of money that is made available to the economy, called the

Answer 30

money supply

Question 31

Decisions by policymakers concerning the money supply constitute

Answer 31

monetary policy

Question 32

The Bank of Canada has the power to increase or decrease the

Answer 32

number of dollars in the economy.

Question 33

Although in practice the Bank of Canada’s methods of controlling the money supply are more complex and subtle than this, the helicopter vacuum metaphor is a good first approximation of the meaning

Answer 33

prices rise when the government prints too much money. Another of these ten principles is that society faces a short-run tradeoff between inflation and unemployment

Question 34

the Bank of Canada’s policy decisions have an important influence on the economy’s rate of inflation in the long run and the

Answer 34

economy’s employment and production in the short run.

Question 35

Recall that the amount of money you hold includes both currency (the bills in your wallet and coins in your pocket) and demand deposits (the balance in your chequing account)

Answer 35

Because demand deposits are held in banks, the behaviour of banks can influence the quantity of demand deposits in the economy and, therefore, the money supply

Question 36

Whenever a person deposits some money, the bank keeps the money in its vault until the depositor comes to withdraw it or writes a cheque against his or her balance.

Answer 36

Deposits that banks have received but have not loaned out are called reserves

Question 37

In this imaginary economy, all deposits are held as reserves, so this system is called

Answer 37

100 percent reserve banking.

Question 38

We can express the financial position of First National Bank with a

Answer 38

T-account, which is a simplified accounting statement that shows changes in a bank’s assets and liabilities

Question 39

On the left-hand side of the T-account are the bank’s assets of $100 (the reserves it holds in its vaults)

Answer 39

On the right-hand side of the T-account are the bank’s liabilities of $100 (the amount it owes to its depositors). Notice that the assets and liabilities of First National Bank exactly balance.

Question 40

if banks hold all deposits in reserve,

Answer 40

banks do not influence the supply of money.

Question 41

Of course, First National Bank has to keep some reserves so that currency is available if depositors want to make withdrawals. But if the flow of new deposits is roughly the same as the flow of withdrawals, First National needs to keep only a fraction of its deposits in reserve. Thus, First National adopts a system called

Answer 41

fractional-reserve banking.

Question 42

The fraction of total deposits that a bank holds as reserves is called the

Answer 42

reserve ratio. This ratio is determined by a combination of government regulation and bank policy. As we discuss more fully later in the chapter, some central banks place a minimum on the amount of reserves that banks hold, called a reserve requirement. In addition, banks may hold reserves above the legal minimum,
called excess reserves, so they can be more confident that they will not run short of cash

Question 43

Let’s suppose that First National has a reserve ratio of 10 percent. This means that it keeps 10 percent of its deposits in reserve and loans out the rest. Now let’s look again at the bank’s T-account:

Answer 43

First National still has $100 in liabilities because making the loans did not alter the bank’s obligation to its depositors. But now the bank has two kinds of assets: It has $10 of reserves in its vault, and it has loans of $90. (These loans are liabilities of the people taking out the loans but they are assets of the bank making the loans, because the borrowers will later repay the bank.) In total, First National’s assets still equal its liabilities

Question 44

Once again consider the supply of money in the economy. Before First National makes any loans, the money supply is the $100 of deposits in the bank. Yet when First National makes these loans, the money supply increases. The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency.

Answer 44

The money supply (which equals currency plus demand deposits) equals $190. Thus, when banks hold only a fraction of deposits in reserve, banks create money.

Question 45

note that when First National Bank loans out some of its reserves and creates money,

Answer 45

it does not create any wealth.

Question 46

At the end of this process of money creation, the economy is more liquid in the sense that there is more of the medium of exchange,

Answer 46

but the economy is no wealthier than before.

Question 47

The creation of money does not stop with First National Bank. Suppose the borrower from First National uses the $90 to buy something from someone who then deposits the currency in Second National Bank. Here is the T-account for Second National Bank:

Answer 47

After the deposits, this bank has liabilities of $90. If Second National also has a reserve ratio of 10 percent, it keeps assets of $9 in reserve and makes $81 in loans. In this way, Second National Bank creates an additional $81 of money. If this $81 is eventually deposited in Third National Bank, which also has a reserve ratio of 10 percent, this bank keeps $8.10 in reserve and makes $72.90 in loans. Here is the
T-account for Third National Bank

Question 48

The process goes on and on. Each time that money is deposited and a bank loan is made, more money is created. How much money is eventually created in this economy?

Answer 48

Original deposit $100.00
First National lending $90.00 [= 0.9 x $100.00]
Second National lending $81.00 [= 0.9 x $90.00]
Third National lending $72.90 [= 0.9 X $81.00]
Total money supply = $1000.00